Are Emerging Markets the Right Investment for You?

Should emerging markets have a place in your investment portfolio? In today’s low yield, low growth environment, some investors are looking outside of the US to generate extra returns on their savings. For some individuals, emerging markets appear attractive on the surface, given their historically robust economic growth rates and higher bond yields. Indeed, there’s a strong fundamental case to be made for investing in emerging markets.  

Yet the task of finding the right opportunities can seem daunting, given the overwhelming differences between markets and risks in this space. Given these issues, you might be asking yourself if emerging markets are right for you. Well, finding the right opportunities likely won’t be easy. Even so, if you have a long investment time horizon, a higher tolerance for risk, and a willingness to learn more about this increasingly relevant part of the world, then investing in emerging markets might be one way to diversify your investment portfolio

Not Your Father's Emerging Markets

Emerging markets have experienced a significant transformation over the past two decades. One simple way to think about the change is in terms of a business startup. Decades ago, many of the world’s emerging markets were seen as metaphorical economic startups that produced low-cost textiles and were a source of the world’s commodity exports.  

 

Indeed, manufacturing offshoring, foreign direct investment, and exporting activity were critical to emerging market growth early on. With the help of early investors and a host of governance changes, many of these countries have today become vital influencers in the global consumer and technological marketplace.  

 

Like a startup business, this rising success has delivered to its population higher levels of financial wealth. That’s why today, a young demographic and higher levels of wealth are likely poised to spur the next leg of growth in the emerging market story.

Why Demographics Matter

So why does the age of a population matter? A young, wealthy population is inclined to spend more on goods and services than one that is aging. According to the economic life cycle hypothesis, young individuals typically focus their early working years on growing earnings while they build up to a certain level of consumption on goods and services. Theoretically, these same individuals will use their savings later on in life to maintain an even-level of spending throughout retirement.  

 

Outside of a purely theoretical framework, we can think of events like getting married, starting a family, and planning for the future as reasons why some younger individuals are more inclined to spend on goods and services than their older counterparts. This spending pattern is also one reason why consumption is likely to play an increasingly crucial role in emerging market growth over the coming years as more developed economies continue to age. How different are the demographics in emerging markets relative to more advanced economies?  

 

Today, over 6.4 billion people live in developing economies, compare to 1.3 billion in more advanced countries. Among many emerging market populations, the median age is now in the low 30’s. In India, for example, over half of its population is below the age of 30. And how does this compare to more advanced economies? 

Well, in Japan, the median age is 49 years old, with only 26% of its population below 30. While the US is generally younger than Japan, only a little more than a third of the population is under 30 compared to 50% for India. And considering that India has four times as many people as the US, you can quickly see how this young, consumption-oriented growth narrative in emerging markets might be primed to accelerate.  

 

Now, it’s not enough to say that a young population can drive economic growth alone. Take Afghanistan, for example. While not an emerging market economy, this impoverished country illustrates how having one of the youngest populations is not the ticket to wealth. What’s missing? A young country poised for growth needs a predictable political, legal, and investment base to provide income opportunities for its growing population. And it’s these critical factors that are missing in Afghanistan but have led to rising wealth in some emerging market countries over the past twenty years.

When Reforms Lead to Structural Improvements

While we talk about emerging markets as a single unit, much of the past growth in this part of the world has been driven by Asia. For decades, countries across Asia have built up wealth by stabilizing their political environments, cutting bureaucratic red tape, and introducing predictable and enforceable rules of law.

 

These actions have arguably underpinned the startup phase of economic growth we mentioned earlier. And these initial efforts resulted in a rise in foreign firms establishing a local presence that brought in billions of dollars in foreign capital investment to emerging market countries.

 

At the same time, leaders made a deliberate effort to reinvest their new-found tax base back into their local economies. These reinvestments included building infrastructure and making it easier for individuals to start small businesses that have given rise to firms that today compete on a global scale. And when we think about economic reforms in emerging markets, China is the most prominent example of this positive outcome.

 

Policy changes by Chinese leader Deng Xiaoping in the 1970s led to an opening up of the country’s economy and ushered in a foreign investment flood. At the same time, policies enacted to reform state-owned enterprises, improving telecommunications infrastructure, and championing its private sector enabled China to create a base for its economic ascendance. And while China’s development is significant, it should be noted that this growth miracle isn’t isolated to China alone.

Singapore (essentially a small city-state) went from a developing country just a couple of generations ago to an essential part of the Asian economy. And today, it stands as a vital global financial center. South Korea is yet another development success story in the region.

 

Reforms allowed local names like Samsung, Hyundai, and others to flourish on the global stage. Today, policy changes in countries like India, Vietnam, and Thailand and efforts among ASEAN nations are paving the way for a new cohort of rising economies and increased wealth for a young population ready to spend.

Broadening Investment Opportunities

Having moved past the startup phase and well into expanding growth, firms in emerging market countries increasingly need more capital as they shift their focus from selling goods and services abroad to their own domestic markets. Funding this expansion through bank loans can be costly and is one reason why business leaders look to capital markets to issue stocks and bonds as a more affordable way to fund operations.  

 

It’s crucial to note that foreign investors play an essential role in these markets. Continued governance improvements and other systemic reforms increasingly make emerging markets an attractive investment destination for outside investors. While some foreign investors might consider the markets small or illiquid, here are two points you should know about capital markets in these countries.  

 

First, while the US remains the single largest financial market globally, emerging markets have become a critical part of the global investment landscape. Today, emerging market stocks represent nearly a quarter of global market capitalization compared to less than 5% at the turn of the century. What’s more, the amount of debt in these countries has risen to 25% of total global debt outstanding, with an investible universe of nearly $12 trillion in debt securities.

 

The second thing to consider is that investing in emerging markets isn’t just about materials, industrials, or financials anymore. Rather, sectors oriented toward consumer spending, technology and healthcare are quickly taking a rising share of emerging market investment opportunities and tracking the economic transformations we’ve discussed.  

 

The point here is that demographic fundamentals are driving a need for emerging market capital investment. A young and increasingly affluent population combined with growing global capital market influence is likely to broaden the set of emerging market investment opportunities available to you in the coming years. 

Finding the Right Investment

Up to now, we’ve laid out the fundamental growth story and capital market opportunities for emerging market investors. And if you’re like many investors, you’re probably asking yourself how you can get started. 

 

While it’s tempting to think of emerging markets as one homogenous group, the reality is that emerging market investing is not like investing in the US. In fact, this universe comprises 27 separate countries that make up emerging markets, each with their varying composition of stocks and bonds, exposure to state-owned and private sector securities, and other factors like company size, sectors, and style. That’s why it’s essential to consider specific risks in this area, before diving in. Let’s begin by taking a look at volatility risk.

Volatility Risk

Emerging markets have a reputation for being higher risk and higher volatility for a good reason. History shows that over the past decade, emerging markets stocks have exhibited higher levels of price volatility than US stocks.

More specifically, equities making up the MSCI Emerging Markets index returned less than 1% annualized over the past ten years yet had more volatility than the large-cap US stocks. Much of this disparity can be explained by differences in regional equity performance in places like Latin America vs Asia and illustrate that higher risk does not necessarily mean higher returns at a broad level.  

Liquidity Risk

Liquidity is another concern for investors in this space. Emerging markets are often influenced by risk-on/risk-off sentiment in global financial markets. In the past, some emerging market governments have welcomed capital inflows during risk-on periods, only to put in place measures to prevent hot capital outflows during times of financial stress.

While some of these liquidity and capital control issues have eased in recent years, this risk nevertheless underscores the point that investing in emerging markets should be done with a long-term view in mind.

Interest Rate Risk

Now when interest rates rise, bond prices fall. This basic fixed income concept illustrates how interest rate risk might be present in emerging markets today. Fluctuating inflation and changes in monetary policy often affect the direction of interest rates in emerging market economies.

One only needs to look at the events in Turkey in recent years to see how political and economic disruptions led to a sharp rise in its central bank policy rate and a rapid decline in bond prices

Currency Risk

Currency risk is another factor to consider. US-based investors not only need to stay on top of emerging market developments, but they must also be aware of what’s happening with the US dollar. When the dollar is weak, investment returns from emerging markets can generally be higher due to currency translation effects.

The opposite is true when the US dollar strengthens. This is notably the case with local currency-denominated debt. How so?  Well, it’s because a weaker foreign currency buys fewer dollars when interest payments are brought home. Either way, staying on top of currency market developments is central to emerging market investing.

Political Risk 

Finally, political risk is one of the top concerns among emerging market investors. Changes in a political regime or legislative structures within these countries can either quickly lead to economic prosperity or its reversal.

Such risks have been acutely demonstrated in Latin America, where various corruption, legal, and other political issues have created uncertainties for investors. What was the result? Well, these developments have arguably led to Latin American equities mostly underperforming the rest of its peers over the past decade and contributing to investment flat performance for emerging markets as a whole.

The takeaway here is that if you plan to get started with emerging market investing, it’s not only essential to understand the narratives that can drive asset prices higher, but also the risks that can move against those opportunities as well.  

Getting Educated About Emerging Markets

Navigating complex risks in an ever-changing market environment can be challenging for even the most seasoned investment professional. That’s why research is a crucial component of any investing journey. And it only becomes that much harder to sift through overwhelming amounts of data and reports when you’re exploring a country or region with little familiarity.

Fortunately, third-party firms have helped simplify the research and security selection process in global markets generally, and emerging markets specifically. One company central to the development of investment strategy within emerging markets is MSCI. MSCI is widely known for its stock market benchmarks. And what’s essential to your research process is understanding the methodology MSCI uses to add securities to its indices.

Pages can be written about the tools, techniques, and computations used by MSCI to build its benchmarks. Even so, here are three ways using MSCI’s research can help in your emerging market investment journey. First, the firm segments capital markets on many factors like capital controls (mentioned earlier) and market capitalization to differentiate between developed, emerging, and frontier markets. 

Second, the indices, in many cases, represent the investible universe available to foreign investors. These factors include free float, which indicates how much of a given company’s stock is liquid and available to foreign investors. This process can help take the guesswork out of knowing which firm could experience wide price swings due to low security marketability.

Finally, it’s important to note that you cannot invest directly in an index. For this reason, many well-known US-based asset management firms have developed investment vehicles that follow a portfolio construction process to mimic MSCI indices. This fact can simplify the security selection process, especially when emerging market investing is not your primary vocation.

Investment research can be an onerous process. Even so, relying on robust third-party resources and tools can help you shorten the amount of time you spend identifying attractive regions and securities within the emerging market universe.

Are Emerging Markets the Right Investment for You?

Emerging markets are transitioning from being the world’s producers of low-cost goods and commodity exporters to high-value, globally relevant investment destinations. These changes have brought wealth to a young population poised to spend, creating a new set of opportunities for global investors. Even with this positive backdrop, is investing in emerging markets right for you?

Well, finding the right opportunities likely won’t be easy. Even so, if you have a long investment time horizon, a higher tolerance for risk, and a willingness to learn more about this increasingly relevant part of the world, then investing in emerging markets might be one way to diversify your investment portfolio.  

About the Author

Peter Donisanu
Peter Donisanu is Chief Financial Strategist and President at Franklin Madison Advisors, Inc. Franklin Madison Advisors is a fee-only fiduciary financial planning and investment management firm based out of Pittsburgh, Pennsylvania and serving clients nationally. We exist to serve a generation that has been underwhelmed by traditional paths to financial security and independence.